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US-China Trade Negotiations What’s Really Going On?

We’re down to the pointy end now. US-China trade negotiations have begun and are continuing. Both countries agreed to a 90-day truce on, 1 December 2018. This implied that come 1 March, the two parties need to have reached an agreement or the tariffs in place increase.

US President Trump announced on 25 February 2019 what had long been assumed: the trade-truce will be delayed, because of the “very productive talks” going on between his administration and Chinese policymakers. Understandably, the formal recognition that tariffs won't be hiked to 25% (from their current rate of 10%) on US$200 billion of Chinese goods, lifted markets.

One could say, for several weeks, in a gradually thinning market recovery, it's been trade-war headlines that have been providing the sugar hit to sentiment to keep the recent market run going at all.

If you can’t build it, steal it

For the US, the tariffs aren’t the issue. The real tension is centred on China’s theft of US intellectual property. Tariffs are simply a means to an end or a means to force negotiations on protecting US intellectual property. Make no mistake, Trump is happy to sit back and collect tariff revenues. “I love tariffs, but I also love them to negotiate,” the President said.

China hasn’t ‘stolen’ intellectual property in the way you might think, although there are some associations to cyber theft. This has come about due to China’s complex legal system that coerces companies to provide full technology patent details when manufacturing products in China. In addition, they compel businesses to switch to state-owned technology and supported Chinese products. This has led to China been given a technological edge, without being innovation leaders themselves.

This process allows Chinese firms to piggyback off others creativity and innovations, and create cheaper products for consumers. Essentially, China has been able to flood the market with cheap knock-offs because of their disregard for intellectual property rights. US Trade Representative Robert Lighthizer estimates this has cost US companies US$50 billion.

This is what kicked off the tariff war at the start 2018, with Trump’s announcement of tariffs on solar panels and appliances that applied broadly, but were mostly aimed at China. It escalated quickly from there, with China announcing retaliatory tariffs and Trump doubling down with more tariffs on Chinese steel and electronics.

China escalated again and the two parties were almost at the point of 25% tariffs on 100% of goods traded between the two countries, before a ‘truce’ was declared in early December to allow time for negotiations.

The point? The tariffs are somewhat of a smoke screen. They were about getting China to the table. Trump’s administration will put a large focus on the end of forced technology transfers as well as addressing limitations on direct foreign investment.

Many observers assumed the trade war would lead immediately to a drastic reduction of US-China trade and a reduction in the US trade deficit with China. Neither of those events has happened. In fact, China’s trade surplus with the US actually hit a new record in 2018 of US$323 billion; a 17% increase in the surplus. Many analysts interpreted the data to mean that Trump’s trade war is a failure and China will ‘win’ the war.

The most logical explanation for the increase in China’s trade surplus is due to US importers trying to buy as much as they could from China before the tariffs were put in place, as it takes about 6 months from the time tariffs are announced to when they apply. Since tariffs were announced between January and June 2018, US importers have been busy stocking up on inventory to ‘beat’ the tariff hikes.

What happens next will be the most interesting….

This year the White House has issued a series of upbeat statements suggesting the trade talks were going well and a positive outcome might be within reach. The Chinese have supported these views. As you may be aware, markets responded positively to the prospect of the trade wars winding down.

In contrast, US Trade Representative Robert Lighthizer told Congress that very little progress has been made on the tough issues of intellectual property and investment restrictions.

Will it be that China is unlikely to concede much on these issues because it relies on pilfered technology to make its own industries globally competitive? Will it be that Trump is unlikely to reach an agreement that does not offer protections in these areas that are substantive and verifiable?

With US businesses loaded up on Chinese inventory, US growth potentially slowing and tariffs finally taking hold - will China’s exports to the US fall off a cliff in 2019?

Do we believe the trade war happy talk going on right now, or is this trade war is about to get much worse? Will the US end the truce and raise tariffs as originally planned in order to force China’s hand?

Or will the mantra of ‘the "very productive talks" going on’ play out as it implies and result in a situation where both nations can claim victory and the so called trade war ends?

Time will tell and the markets will react accordingly, to price in every detail of the outcome.